Banks are viewed as villains across the world. But these villains can sometimes also be victims. In Pakistan, banks have been on the receiving end for some years now owing to the government’s need to enhance its tax revenues without broadening the net, as well as its demands from bankers to invest in the rulers’ political ambitions.

The corporate tax rate for banks is 35 per cent — or 6pc higher than 29pc for non-banking businesses. Besides, capital gains and dividend income streams for banks are also taxed at the same rate as opposed to the reduced rates for other companies. On top of that banks are required to pay ‘super tax’ at the rate of 4pc. The tax was levied in 2015 on banking and non-banking companies to fund the rehabilitation of the Internally Displaced People (IDPs) in the ex-Fata (Federally Administered Tribal Areas) region of Khyber Pakhtunkhwa a year after the launch of the military operation against militants. Initially, it was imposed for one year but the government kept extending it every year until it was phased out for the non-banking companies in 2019 but extended for an indefinite period for banks.

The tax story of the banking industry doesn’t end here. Banks are charged additional income tax on their profit from their investment in the short- to long-term government debt — such as T-bills and PIBs — to meet the needs of the resource-starved government. “Different rates apply depending on a particular bank’s ADR (Advances to Deposit Ratio),” the chief financial officer (CFO) of a big bank told Dawn on condition of anonymity.

The effective tax rate for a bank with an advance to deposit ratio below 40pc would be approximately 42.5pc and a little less for those lenders with a higher ADR than 40pc

Banks with ADR below 40pc are subject to 5pc additional tax (on top of 35pc corporate tax on overall profits from both advances and investments in government debt) on their profits from their investments in the government papers and 2.5pc if their ADR is between 40pc and 50pc. “In other words, the effective tax rate for a bank with an ADR below 40pc would be approximately 42.5pc and a little less for those lenders with a higher ratio than 40pc,” the CFO claims.

This measure was taken by the government to ostensibly penalise banks for not lending enough to the industry and other sectors of the economy and maximising their profits through investment in the government debt. “This forced lending approach, however, significantly impairs and undermines the credit underwriting standards of banks,” he argues.

According to the State Bank of Pakistan’s quarterly compendium on the banking industry, the effective tax rate on banking profit stood at around 43pc in the 1HCY21 to June as they were charged a total tax of nearly Rs94.5 billion on their pre-tax profit of Rs217.3bn. The effective tax rate on banking companies in the last three years has ranged between 38pc-44pc.

Banks’ ADR has been fluctuating between 39pc and 41pc since CY18, rising to 43pc during H1CY21. Likewise, their IDR (Investment to Deposit Ratio) vacillated between 39pc in CY18 to 58pc in CY20 before going up to 69pc in the period between January and June this year. Most of their investments remain in the public-sector debt due to the cash-strapped government’s huge appetite for cash to meet its budgeted expenditures. The ADR/IDR numbers highlight how much the government must be making from its penalising levies on banks.

Fahad Rauf, a financial analyst, says banks are easiest for any government to tax. “With one of the world’s lowest tax-to-GDP ratio of around 11pc, banks offer a good source of revenue for the government struggling to bridge its fiscal deficit,” he argues. “Besides, there is a feeling in the government that it is justified to subject banks to heavy taxation since they are making a lot of money from its securities.”

Heavy taxation is but only one part of the financial burden banks are bearing. Different kinds of fees, penalties and fines on account of other regulatory mandates are also eating into their profits. For example, the SBP has created a Deposit Protection Company to insure deposits of up to Rs500,000 per account holder in case of a collapse of a bank. Instead of charging a premium from banks only on the amount of deposits eligible for insurance under it, the premium is calculated on the basis of an account holder’s total deposits even if those exceed the insurance coverage.

Additionally, the regulator has set some mandatory targets for banks to meet, failing which attracts significant regulatory penalties. Banks are, for instance, given targets to disburse a certain percentage of their private sector credit to SMEs (small and medium enterprises) and agriculture. Then banks are required to increase their lending spread across the provinces to give people of remote areas access to finance whether demand exists or not. Yet there is no restriction on the borrower to invest that loan in the region from where they had obtained it.

The recent SBP mandate for banks to increase their exposure in the construction and housing industry to 5pc of their total outstanding private sector credit exposure to support the prime minister’s housing initiative is being viewed by bankers as the cream on the top. “If a bank cannot or does not meet the quarterly housing finance targets it will be penalised. That’s not all. We’ve been asked to boost our mortgage finance to 5pc of our total outstanding private sector credit and not just of the new disbursements,” the CFO explains.

On top of that banks are supposed to shoulder the entire risk on small-ticket subsidised financing for housing under the Naya Pakistan Housing Project. Banks are reluctant to increase their exposure in this segment because of the absence of strong foreclosure laws that would allow them to repossess the property in case of default. “You cannot boost the mortgage finance market through mandatory targets; you have to create a helpful environment for the lender to make them feel that the money of their depositors is secure.”

Mr Rauf says the central bank’s regulations forcing banks to lend money to the under-served sectors stems from its desire to encourage banks to reduce their exposure in government debts and shift their money to areas that can help push growth and investment. “But that is not easy since the government’s need for cash to finance its budget deficit runs counter to all such efforts. In the case of mortgage finance, it will not be possible to enhance the market without implementing really effective foreclosure laws to provide comfort to bankers who are already having a hard time dealing with legacy defaults.”

As a consequence of the regulatory and tax burdens, banks are watching a downward trend, with foreign investors taking out their capital from banks in recent years. The situation demands a review of tax policies and regulations to ensure the operational capability of the industry.

Published in Dawn, The Business and Finance Weekly, November 1st, 2021